Analyzing Stock Values

If you consider the striking price to be fair and reasonable for 100 shares of the underlying stock, selling puts has two advantages:

You receive cash at the point that you sell a put.

The premium you receive discounts your basis in the stock in the event of exercise.

If you are willing to purchase shares of stock at the striking price, then selling puts is a smart strategy. You may even argue that there is no actual risk because you believe the stock price is reasonable. If, as an alternative, you were to purchase 100 shares of stock today, you would pay the current price without receiving a premium for selling a put; and the market value is just as likely to decline as if you were to sell the put.

Buying shares above market value may be acceptable if you plan to keep those shares as a long-term investment, considering (a) the discounting effect from selling puts and (b) the possibility of generating profits from selling puts that are not exercised.

If the difference between striking price and current market value at the time of exercise is greater than the amount you received in premium, you have a paper loss at the point of exercise. In that outcome, you will need to wait out the time required for the stock's price to rebound before you can recapture that loss. You may be able to offset this loss by selling covered calls against stock acquired in this manner.

Acquiring stock through writing puts has to be done with the stock's value as the essential element in the decision. Remember, value does not mean the current market value of the stock; it means the price you are willing to pay per share. Put sellers, like call sellers, usually prefer to avoid exercise, so they use rolling techniques, such as rolling forward and down, for example, to either defer exercise or reduce the eventual exercise price. Once you identify the degree of risk involved with exercise, you need to compare that to the premium income in order to determine whether placing yourself in a short position is worth that risk exposure. If you embark on a program of put writing, you will need to have available adequate capital to purchase the shares of stock involved, an important factor that limits the degree of put writing you are likely to undertake. In fact, you will be required to have adequate funds on hand in your brokerage account. If you experience a high volume of exercise, you will use up your available capital and fill your portfolio with shares of stock acquired above current market value. So you naturally need to limit put writing to those stocks you would like to own whether you wrote puts or not.

Example

Calculating the Put Advantage: You sold a put with a striking price of 55 and received 6 (discounting the net price per share to $49). You considered $49 per share a reasonable price for those shares. Before expiration, the stock's market value fell to $48 and your put was exercised.

Two observations need to be made concerning this transaction:

The outcome is acceptable as long as you believe that &dollar;49 per share is a fair price for the stock. You would then also believe that current market value -- only one point lower than your basis -- is likely to rebound in the future. If your assumption is correct, the loss is a paper loss only and it will turn out to be a worthwhile investment.

If the stock's market value had risen, you would have profited from selling the put. It would not have been exercised and would have expired worthless; or time value would have evaporated, enabling you to buy to close at a profit. In those outcomes, the put premium would have been all profit. So selling puts in a rising market can produce profits when you are unwilling to tie up capital to buy 100 shares; this can be achieved with limited risk exposure.

Put sellers who seek only the income from premiums need to select stocks that they consider to be good prospects for price increase. Premium value is only half the test of a viable put sale; the other half is careful selection of stocks. As a put seller, you have to be willing to acquire 100 shares of stock for each short put written. If risks are too great, or if you do not want to acquire shares, then you cannot justify the strategy.

By Michael C. Thomsett

Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.